Book Notes: Spend ‘Til The End, Part I

There are three parts to an economics-based approach to financial planning:

1 – Maximizing your spending power. Making financial choices that provide you with more money to spend for the same effort. For instance, whether to collect a smaller Social Security benefit at age 62, or a larger benefit later. Making the right choice doesn’t take any more time or effort than the wrong one, but the consequences on your living standard can be huge. Same for jobs, mortgages, etc.

2 – Smoothing your standard of living. Economists call the spreading of your spending power over time “consumption smoothing.” It ensures you have spending power in good and bad times, and enables you to spend ’til the end. It doesn’t mean starving now to feast later – or vice versa. It means being able to sustain your family’s living standard over time, as you age, no matter what.

3 – Price your love. No, not on Craigslist. This refers to knowing what it costs in terms of your living standard to do the things you love. For instance, taking a wonderful but low-paying job.

The authors believe we are all financially sick. (Literally. Chapter 1: “I Am Financially Sick.”) We spend too little, save too much, take too many risks, take no risks, gamble, shop compulsively, buy lottery tickets, under-insure, hold the wrong stocks, make spontaneous buys, fail to diversify, max out our credit cards, take on too much debt or drown in it. And that’s just on Monday.

But consumers aren’t fundamentally irresponsible. There’s a ton of bad advice out there, much of it coming from institutions who make money by selling financial products. Common rules of thumb like “save 15% of your income” are woefully lacking. Most institutions’ online calculators are biased towards oversaving, since those institutions make more money by selling “riskier” products to make up for a lack of savings.

Consumption smoothing should be the goal – an even, sustainable living standard throughout your life. Financial planning as practiced on Wall Street, though, leads to consumption disruption. Small mistakes in initial assumptions often become huge mistakes in how much you’re told to save and how much life insurance you buy. Because the probability of making planning mistakes is quite high, conventional advice often transforms oversavers into undersavers and vice versa. To the authors, financial planning is often just a marketing tool.

Chapter 4 was called “Pimping Risk.” For some reason I found this hilarious. Also, Wall Street is not your friend.

2 – Typical households should hold relatively more stock than the rich. Low and middle income groups have fewer financial assets as a percentage of income. In addition, their living standard is reasonably safe due to labor earnings and government benefits. They therefore stand a lower chance of suffering a drop in living standards compared to a family living exclusively off investments.
3 – Diversifying your portfolio is generally a bad idea. In the margin here I wrote “buy these guys a beer.” As the authors point out, a majority of our economic resources are already tied up in bond-like resources such as social security, retirement benefits or other nonfinancial assets. In that light, diversification would actually mean concentrating financial assets in stocks.

4 – Stock holdings should rise, fall, rise and fall with age. Take that, life cycle funds! The amount of stock you hold should reflect your commitments and capacities throughout life. The authors recommend having just a bit in stocks when very young, considerably increasing your allocation to stocks in middle age, reducing your holdings as retirement approaches, increasing it again in early retirement and then, finally, reducing it again in late retirement – assuming you can remember. I’ll be happy if I’m still wearing pants then.

5 – Having children may lower your need for life insurance. No, not because kids drain the life out of you. (Just kidding, guys!) In the economic sense, the more kids you have, the more you lower your living standard. So, you can reduce the protection level required because there is a lower standard to maintain. Children also come along with their own life insurance polices on their parents’ lives, such as social security children’s survivor benefits. Only an economist can get away with this argument, by the way.

6 – Spouses or partners with the highest earnings may need the least life insurance. If your spouse is younger than you or expects to retire later, that spouse may have more lifetime earnings to protect than you.

7 – The rich have bigger saving and insurance problems than others. Because of its progressive benefit formula, Social Security retirement and survivor benefits replace a much larger fraction of the earnings of most workers than the rich.

8 – Maximizing retirement account contributions is generally undesirable. The majority of young and middle age households are cash-constrained due to mortgages and home/auto loans bundled with other off-the-top expenses. When such households maximize retirement contributions, it often translates into a cut in current living standards…leading to a higher living standard in old age. Again, the idea is to smooth that consumption.

9 – Waiting to take Social Security can dramatically raise your living standard. If you wait just an extra year to collect benefits, they are permanently increased by approximately 8% (over and above inflation) due to compounding.

10 – Oversaving and overinsuring are very risky. Oversaving will result in a cut in your present living standards, and should you meet your demise as soon as you reach retirement, it will have all been for naught. When you overinsure, you risk living too long and never benefiting from the insurance money, despite cutting your current living standard to pay those premiums.

11 – Mortgages offer no tax advantages for most households. A majority of low and middle income households are unable to deduct mortgage interest since they don’t itemize their deductions. Itemizing is not very beneficial even for those who do it as there is no real tax advantage of having a mortgage. That logic is explained via an example: Assume you can pay off your mortgage but don’t and instead invest in bonds. The interest you earn from bonds is lower than the mortgage interest, and interest received on bonds is also taxable. So, the vast majority of people would better off by paying off the mortgage.